>Punitive Damages and Taxes

Much is said about punitive damages and how they are used to punish wrongdoers. Plaintiffs dream of large punitive damage awards. Plaintiffs’ lawyers who obtain large punitive damage awards use them to brag about their ability as tort lawyers and a bludgeon on other defendants to convince them to settle for more than they owe. What the litigants and litigators seldom consider carefully is the tax consequences of a large punitive damage award. Failure to properly advise a plaintiff seeking punitive damages about the tax consequences of success can result in claims of legal malpractice.

What is the Purpose of Punitive Damages?

Punitive damages are intended to punish the wrongdoer. They do not compensate the plaintiff for lost wages, pain, suffering, property damage or any other damages designed to place the plaintiff back the way he was before the tort caused damage. Punitive damages are considered, therefore, a windfall to the taxpayer and must be be included in taxable income. Section 104 of the Internal Revenue Code deals with the treatment of punitive damages. Section 104(a)(2) excludes from income only “damages (other than punitive damages) received . . . on account of personal physical injuries or physical sickness.” Therefore, punitive damages, even in connection with personal injuries, may not be excluded from income.What Happens When the Recipient of Punitive Damages Fails to Pay Income Tax on the Recovery?

In Gary L. Greenberg and Irene Greenberg v. Commissioner of Internal Revenue, No. 25420-07. (U.S.T.C. 01/24/2011) the United States Tax Court dealt with a recipient of insurance bad faith punitive damages who tried to avoid tax on the award. As a result the recipient of the award of punitive damages for the bad faith conduct of their insurer, resulted in a major tax consequence and not the windfall the plaintiffs thought they received. Because the Greenbergs could not convince the Tax Court of their position the Court not only slapped the Greenbergs down in affirming a tax deficiency of over $1 million, but further sanctioned them with an accuracy-related penalty, because the taxpayers had neither substantial authority, nor reasonable cause underlying their posture on the damage award.

The Tax Court noted that the definition of gross income broadly encompasses any addition to a taxpayer’s wealth. Therefore, absent an exception by another statutory provision, damage awards from a lawsuit must be included in gross income.

In general, exclusions from income are narrowly construed by the tax court. The Greenbergs argued that the punitive damages they received in their insurance bad faith case may be excluded from income under section 104(a)(3) primarily because punitive damages could not have been awarded without the insurance policy. The Tax Court discounted the “but for” argument, and found it was discredited by the Supreme Court’s analysis of section 104(a)(2) in O’Gilvie v. United States, 519 U.S. 79 (1996). In that case the Supreme Court considered an earlier version of section 104(a)(2) that excluded from income “the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness”. The Court reasoned that both the statute and the intention of Congress to exclude only those damages that compensate for personal injuries or sickness indicated that the exclusion does not include punitive damages. The Tax Court noted the clear intent of the law as follows:

Any punitive damages award arguably is made because of some injury and thus would not be awarded “but for” the injury. Punitive damages are for the purposes of punishment, not compensation for “personal injuries or sickness” and therefore do not meet the requirements of the statute.

The Greenbergs claimed to the Tax Court that the punitive damages they received were not punitive, but “bad faith damages”. They contended, without citation to any relevant authority, that “damage awards that serve both to compensate and punish are excludable”. The tax court did not buy the argument because “bad faith damages” are, by definition, “punitive damages” and that the punitive damages they received were ineligible to be excluded because they are not compensating “for personal injuries or sickness.” The Tax Court also noted that the legal fees and costs received in a judgment that correspond to taxable damages are also taxable.

Penalty Assessment

Section 6662(a) and (b)(1) and (2) imposes a 20-percent accuracy-related penalty on any underpayment of Federal income tax attributable to a taxpayer’s negligence or disregard of rules or regulations or substantial understatement of income tax. A substantial understatement of income tax exists if the understatement exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000.

Example

Consider an insurance bad faith judgment where the jury awards the plaintiffs $1,000,000 in compensatory damages and $9,000,000 in punitive damages. The Plaintiffs’ lawyer, in a standard contingency fee agreement, takes 40% of the gross award or $4,000,000 and expenses of $500,000 for experts and other litigation expenses. The plaintiffs’ share of the recovery is $5,500,000. If the Plaintiffs live in California or New York they will pay approximately 39% federal income tax and approximately 10% state income tax on their gross earnings in that year. Assuming the Plaintiffs earned nothing in the year of the judgment they are responsible to pay taxes on the $9,000,000 punitive damage award or slightly less than $4,500,000. In essence they receive none of the punitive damage award and the lawyer only pays taxes on his $4,000,000 recovery of legal fees. Also, if they attempt to avoid paying tax on the punitive damage award they may be assessed a 20% penalty.

The Need for Tax Advice Before Suit or Trial

Most tort lawyers – both plaintiff and defendant – are not knowledgeable about tax consequences. Counsel for plaintiffs who are seeking punitive damages should carefully advise their clients of the tax consequences of the recovery of punitive damages if they know enough or should require that each plaintiff seek the advice of a tax professional before agreeing to proceed with a suit or trial seeking punitive damages. If the Greenbergs had consulted with tax lawyers and been advised that they would be required to pay the top tax rate on the full amount of punitive damages awarded to them (even though 40% to 50% of those damages were paid as part of the contingency fee agreement with their lawyers, they might have agreed to the defendants’ settlement offers that did not include punitive damages.

Is this The End of the Tort of Bad Faith?

In 2008 I wrote an article titled: “Time to Put A Stake Through the Heart of the Tort of Bad Faith”.

In that article I noted:

The law of unintended consequences came into play and instead of protecting the consumer imprecise language, an attempt to force insurers to deal “fairly” with the insureds, resulted in thousands of lawsuits determined to impose penalties on insurers for attempting to enforce ambiguous “easy to read” language. The multiple lawsuits cost insurers and their insureds millions (if not billions) of dollars to get court opinions that interpret the language and reword their “easy to read” policies to comply with the court decisions. For more than thirty years the unintended consequence of a law designed to avoid litigation has done exactly the opposite.

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In more than 60 years of application across the U.S. the tort of bad faith has not had a salutary effect on the insurance business. Insurance costs more than is reasonable or necessary so that sufficient funds exist to pay claims and tort damages from those insureds who believed they were done wrong. Suits relating to claims presented for the 1994 Northridge earthquake in California are still pending seeking tort and punitive damages for failure to pay what the insureds’ believed they were owed. In Louisiana and Mississippi multiple millions were paid to settle claims that flood damage was covered as a result of hurricane Katrina although the policies excluded flood and the plaintiff insureds failed to buy flood insurance. Abuse of insurers is so rampant and so successful that lawyers argue of multimillion dollar fees and have even attempted to (or successfully) bribed judges to increase their recovery.

The tort of bad faith is like the mythical Vampire. It hides in the dark. The truth about the tort of bad faith will die only if it is put into the light of day. It does not solve the problem anticipated. Rather it makes a few lawyers very rich, a few insureds receive indemnity for which they did not bargain and makes the cost of insurance to those who wish only to receive the benefits of the contract prohibitive.

The tax consequences on the plaintiff merely adds to the application of the law of unintended consequences. If only lawyers obtain the benefit of punitive damages and what the Greenbergs claimed to be “bad faith” damages much effort is being incurred to make some lawyers rich and the litigant in worse shape than they would have been had no punitive or bad faith damages been awarded.

More E-Books by Barry Zalma

Available at http://www.zalma.com/zalmabooks.htm including:
"Zalma on Diminution in Value Damages 2012"
"Heads I Win, Tails You Lose -- 2011"
"The Truth, The Whole Truth and Nothing But the Truth"
"Zalma on California Claims Regulations - 2011"
"Zalma on Rescission in California"
"Arson for Profit" a novel
"Insurance Fraud"
"Murder and Insurance Fraud Don't Mix" a novella
All are published in Adobe Acrobat .pdf format and can be read on any I-Pad, I-Phone, Kindle, book reader, smart phone or computer.

New E-Books

"Zalma on Diminution of Value Damages -- 2013"

This is the 2013 edition of Zalma On Diminution In Value Damages. It has been totally rewritten with more 910 pages of material. It is the most extensive and detailed coverage of the issue and how to apply diminution in value damages to losses to property. The E-book Zalma on Diminution In Value Damages – 2013 was written to provide sufficient information to those who became interested in the issue since the Georgia Supreme Court decided State Farm Mutual Automobile Insurance Co. v. Mabry, 274 Ga. 498, 556 S.E.2d 114 (Ga. 11/28/2001).

Available at http://www.zalma.com/diminution.htm,

"Zalma on California SIU Regulations"

"Zalma On California SIU Regulations" is designed to assist California insurance claims personnel, claims professionals, independent insurance adjusters, special fraud investigators, private investigators who work for the insurance industry, the management in the industry, the attorneys who serve the industry, and all integral anti-fraud personnel working with California admitted insurers to comply with the requirements of California SIU Claims Regulations.

The state of California, by statute, requires all admitted insurers to maintain a Special Investigative Unit (an "SIU") that complies with the requirements set forth in the Special Investigative Unit Regulations (the "SIU Regulations") and train all integral anti-fraud personnel to recognize indicators of insurance fraud.

It is necessary, therefore, that insurance personnel who are engaged in any way in the presentation, processing, or negotiation of insurance claims in California be familiar with the SIU Regulations imposed by the state on all insurers doing business in the state.

Available at http://www.zalma.com/zalmabooks.htm.

"Zalma on California Claims Regulations - 2013"

The 2013 issue adds information on a September 2012 ruling by an administrative law judge that prohibits the enforcement of many of the Regulations because they violate, by unlawfully expanding, the meaning of California Insurance Code Section 790.03(h). The new edition was rewritten and includes detailed analysis of the ruling by California Administrative Law Judge Stephen J. Smith who issued a 51-page ruling finding the CDI’s Fair Claims Practices Regulations (FCPR) might not be brought as unfair claims acts. The ruling affects how the CDI has imposed, and will impose in the future, penalties against insurers for claims since the inception of the FCPR in 1992.

None of the standards prescribed in the FCPR appear anywhere in California Insurance Code § 790.03 (pursuant to which statute the CDI adopted the FCPR); these are additional standards added exclusively by regulatory action of the CDI.

The FCPR as applied are unenforceable pursuant to California Government Code §§ 11152 and 11342.2, which establish the test for determining the validity of regulations. Specifically, the court held that § 2695.1 of the FCPR improperly creates new unfair standards and duties within the meaning of Insurance Code § 790.03(h), which subjects insurers to the penalty provisions of Insurance Code § 790.035 for failure to meet those standards.

The FCPR through CCR § 2695.1(a) dramatically and impermissibly expands the scope, nature and reach of the 16 unfair claims settlement practices set forth in Insurance Code § 790.03(h)(1)-(16). The court held that new unfair acts may only be promulgated by the legislature or through the process set forth in Insurance Code § 790.06.

The CDI’s language in CCR § 2695.1 impermissibly amends Insurance Code § 790.03(h) such that a violation can be proved by means of a single knowing act or by proof of a general business practice, which amendment lowers the burden of proof and quality of evidence necessary for the CDI to prove a violation of § 790.03(h). In order to assert a violation of § 790.03(h), proof must be shown that the violation was both knowingly committed and performed with such frequency as to reflect a general business practice.

An OSC drawn from the conclusions or statements in a Market Conduct Examination is improper to support a valid pleading. Such examinations lack specificity about each act. OSC pleadings must assert violations under Insurance Code § 790.03(h)(1)-(16) and pleadings must set forth the charges and allegations in ordinary and concise language, such that the acts or omissions of which the respondent is charged may be reasonably ascertained.
"Zalma on Rescission of Insurance in California - 2013"

Insurers in California have the right to rescind a policy of insurance if the insured misrepresents or conceals a material fact when seeking insurance. California, more than a century ago, adopted, and codified, the ancient Marine Rule with regard to the interpretation of insurance contracts created as a result of misrepresentation or concealment of a material fact allowing rescission even if the concealment or misrepresentation was innocent or unintentional.

Available at http://www.zalma.com/rescission.htm

"Random Thoughts on Insurance"

Since 2010 I have been writing a blog post at least five days a week. This e-book is a collection of those posts that reveal my interest in insurance case law. Some of the cases reviewed were important. Some were of first impression. Others will be totally unimportant. All were interesting to me and I hope are interesting to the reader.

The book is available at http://www.zalma.com/RANDOMTHOUGHTS.htm
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"Zalma on Insurance Fraud - 2012"

Barry Zalma has totally rewritten his seminal E-Book on insurance fraud and has added over 600 pages to the original book.

It is the purpose of the E-book to provide information to those who are engaged in the effort to reduce insurance fraud. It will provide information for the lawyers representing insurers so that they can adequately advise their clients who are victims of the crime of insurance fraud.

This E-book will provide information for insurance claims investigators, special insurance fraud investigators working at insurance company Special Investigation Units (SIU), Fraud Bureau Investigators, and Prosecutors will have the information needed to allow prosecution of insurance criminals to proceed. Prosecutors will also have sufficient information to understand the importance of the crime and the need to reduce the crime by effective prosecution and punishment of the insurance fraud perpetrators.
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"Zalma On Diminution In Value Damages - 2012"

The 2012 edition of Zalma On Diminution In Value Damages. It has been totally rewritten with more than 240 pages of new cases and statutes. It is the most extensive and detailed coverage of the issue and how to apply diminution in value damages to losses to property. The E-book Zalma on Diminution In Value Damages – 2012 was written to provide sufficient information to those who became interested in the issue since the Georgia Supreme Court decided State Farm Mutual Automobile Insurance Co. v. Mabry, 274 Ga. 498, 556 S.E.2d 114 (Ga. 11/28/2001).

Because of the differences in the various jurisdiction and apparent confusion concerning diminution of value damages this E-Book was created to more thoroughly review how each jurisdiction in the United States deals with the issue. The E-book covers each of the fifty states of the United States, the District of Columbia, Guam, Puerto Rico, the 12 Federal Circuit Courts of Appeal and the U.S. Supreme Court.
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"Zalma on Insurance" at http://www.zalma.com/zalmabooks.htm.

Every lawyer retained to prosecute or defend a civil suit should begin the representation with efforts to find insurance coverage for the benefit of the client. Indeed, a lawyer that does not know the law of insurance is litigating with duct tape firmly placed across his or her mouth.
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"Murder and Insurance Fraud Don't Mix" -- A Novella Only $5.00

A new Novella from Barry Zalma involving an insurance fraud that goes terribly wrong when the perpetrator finds it necessary to murder the only possible witness to the crime. Follow the actions of MOM, the insurance company investigator who discovers the fraud and helps the police bring the killer to justice.

To buy go to http://www.zalma.com/zalmabooks.htm.

Zalma on Insurance Is a LexisNexis Top Blogs for Insurance Law – 2011!

Zalma on Insurance has been selected as a LexisNexis Top Blogs for Insurance Law – 2011! Selections were made by the LexisNexis Insurance Law Community staff in consultation with the Insurance Law Community Advisory Board members. The Top Blogs contain some of the best writing out there on insurance law. They contain a wealth of information for the insurance law community with timely news items, practical information, expert analysis, practice tips, frequent postings, and helpful links to other sites. These blogsites demonstrate how bloggers can impact the world of insurance law. You can read the full announcement and list of honorees at http://www.lexisnexis.com/community/insurancelaw/blogs/topblogs/archive/2011/11/11/the-winners-the-insurance-law-community-top-blogs-for-2011.aspx.

Zalma On Insurance — The Blog

After more than 40 years acting as a claims person and insurance coverage lawyer I enjoy reading court decisions concerning insurance. The idea of this blog is to find new cases that are interesting to me and then write a summary. Some of the cases reviewed will be important. Some may be of first impression. Others will be totally unimportant. All will be interesting.
The blog is also intended to act as an almost daily update of the E-Book "Zalma on Insurance" available at http://www.zalma.com/zalmabooks.htm.

Insurance Claims: A Comprehensive Guide

by Barry Zalma, J.D., C.F.E
Now available on CD and electronically so that you can take it with you on your I-Pad, book reader or laptop.
This one-of-a-kind Guide covers the fields of property insurance claims, liability, and fraud. It is ideal both as a detailed reference for the insurance professional and as a plain language guide for those—such as attorneys and business owners—who frequently interact with the industry. In addition to examining the nature of property and liability policies and the processing of claims under these policies, the Guide discusses the complexities of such topics as underwriting, bad faith, subrogation and salvage, duties of the insured and insurer, and declaring a policy void.
Details at http://www.stpub.com
To Purchase: Call 1-800-251-0381 or email orders@stpub.com

Construction Defects

Construction Defects : Litigation and Claims
Barry Zalma, J.D., C.F.E.
Construction Defects: Litigation and Claims explains how to investigate, prosecute, or defend cases that address construction defects-one of the most active areas of litigation in the United States.
To Purchase: Call 1-800-251-0381 or email orders@stpub.com

Mold: A Comprehensive Claims Guide

Barry Zalma Esq., C.F.E.
Mold: A Comprehensive Claims Guide is designed to assist anyone faced with claims for property damage or bodily injury to third parties, or damage to property owned by the insured as a result of claimed exposure to mold, fungi, or bacterial infestations. It moves through the claim process, from the initial report of the claim to the final resolution, proof of loss, and payment. It provides guidance to anyone confronting losses caused by mold, and addresses the obligations imposed on insurers, including underwriting against mold claims and investigating potential fraud claims. Property owners and insurance companies alike will find Mold: A Comprehensive Claims Guide a valuable resource for presenting cases and preparing mold claims.
To Purchase: Call 1-800-251-0381 or email orders@stpub.com

DISCLAIMER

This Blog is made available by the lawyer or law firm publisher for educational purposes only as well as to give you general information and a general understanding of the law, not to provide specific legal advice. By using this blog site you understand that there is no attorney client relationship between you and the publisher. The blog should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.